Obama Proposes to Eliminate Some Capital Gains Taxes — Yes!

I saw in today’s Wall Street Journal that the Obama Administration yesterday proposed the elimination of capital gains tax “on investments in eligible small businesses held for more than five years.  The provision, which Mr. Obama has been promoting since he ran for President, was enacted last year on a temporary basis and expires at the end of 2011.”

This is clipped from the White House web site:

Administration Will Propose Permanent Elimination of the Capital Gains Tax on Certain Small Business Stock:  The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 provides a 100-percent exclusion from tax for capital gains realized on the sale of certain small business stock held for more than five years.  The amount of gain eligible for the exclusion is limited to the greater of $10 million or ten times the taxpayer’s basis in the stock. This provision applies to qualified small business stock issued after December 31, 2010, and before January 1, 2012.  The Administration’s FY12 budget proposal would make this provision permanent, increasing private sector investment in small businesses.

The Wall Street Journal goes on to say that only C Corporations, which unlike other small businesses pay corporate taxes, are eligible. They also must have less than $50 Million in assets, and certain businesses such as law, accounting and investment firms are excluded.

Almost all larger corporations with more than 100 shareholders and virtually all publicly traded companies are C corporations. Most companies that are considering going public, seeking venture capital, or taking on equity investors are C corporations.  I run across a fair number of them in Silicon Valley.

I do not yet know any specifics of the proposal beyond what’s stated here — and the devil’s in the details — but I think that this is a step in the right direction.  I hope that Congress approves it, or at least some version of it, for a number of reasons, cited below:  (People will quibble with the details of the President’s proposal, and suggest other tax changes. I am not evaluating or commenting on overall tax issues in this posting, only cap gains, and have many other questions, such as about dividend treatment, level of corporate taxation, etc.)

• This change will address what I perceive to be an inherent unfairness in the tax code, affecting the outright or partial sale of a company. While this change only affects smaller companies, it will offer relief and stimulus to a large number of them.  The existing taxation on C corporations is onerous, as the corporation itself is taxed, then the shareholders are taxed personally.  This results in a “double taxation” effect for the owners of a C corporation, such that when a C corp. is sold, if the transaction is not structured in such a way to shield shareholders from the full brunt of this taxation, C corp. shareholders may pocket a third less than what S corp. shareholders would pocket, net of taxes. Shareholders of corporations that have made a “Sub-chapter S election,” so called “S corporations,” are not subject to double taxation.
• Economic studies have shown time and again that low capital gains tax treatment serves as a stimulus to the economy and builds employment.  We want to stimulate investments in new businesses, and the level of cap gains tax treatment is an important lever, as low rates encourage investment.
• In the past decade, small businesses — those with fewer than 500 employees — have created 60-80% of the nations net new jobs each year . More than half of Americans are employed by a small business, and these companies generate over half of the U.S. GDP.  (WSJ, Recession Batters Small Businesses, 26-Dec-2008)
• But, let’s drill deeper. That “Small Business” definition of under 500 jobs is too broad to really be useful.  Categorize that under the “Conventional Wisdom of Job Creation.”  So, where do the jobs really come from?
• It’s not so much business size that matters.  It’s business age.  According to the U.S. Census Bureau, nearly all net job creation in the U.S. since 1980 has occurred in firms less than 5 years old.  A 2009 Kauffman Foundation report shows that as recently as 2007, 2/3 of the jobs created were in such firms.  In other words, to reduce unemployment, we want capital to flow toward entrepreneurial endeavors.

In sum, favorable capital gains treatment, and the certainty that Congress will not change that in the foreseeable future, will have a directly beneficial effect on new venture creation and job growth, while providing a more fair tax treatment for shareholders of C corporations in comparison to S corporation shareholders.

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